Asset Liability

Management
CHAPTER 12
Introduction
ALM is concerned with matching of assets and liabilities on the balance sheet of
a firm to avoid the adverse impact of interest rate changes on its profitability
and financial position
Very important in the banking industry
Two main activities of banks are to collect deposits and to lend
In performing these activities, banks face two types of mismatches:
Introduction
[1] Mismatch between the amount of money collected through deposits and the
amount of money lent to borrowers
This mismatch gives rise to funding liquidity risk: The risk of being unable to
raise funds quickly and at a reasonable cost to meet obligations as they become
due
[2] Mismatch between the maturity and interest-rate sensitivity of assets (loans)
and liabilities (sources of funds)
This is the source of interest rate risk
Changes in interest rates have an impact on the profitability and the net worth
of the bank
Objectives of ALM
The main objectives of ALM in the banking industry are:
[1] Achieving stability of short-term profitability [Measured by variations in NII]
[2] Maximizing economic value of the firm [EV is the NPV of cash flows over a
long period of time]
[3] Minimizing funding liquidity risk

The first two objectives are related to control of interest rate risk
The third objective is related to control of liquidity risk
Interest Rate Risk: Measurement
Gap analysis is used to assess interest rate risk or liquidity risk
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝐺𝑎𝑝 = 𝑅𝑆𝐴 − 𝑅𝑆𝐿
RSA: Rate-sensitive assets
RSL: Rate-sensitive liabilities
The RSA and RSL are grouped into time buckets according to their residual
maturity or their next repricing date, whichever is earlier

Further Reading

Further Reading
Interest Rate Risk: Measurement
A positive interest rate gap in a time bucket means RSA exceeds RSL, i.e., assets
reprice before liabilities
◦ This happens when short-term assets are financed by long-term liabilities
◦ NII increases with increase in interest rates, and vice versa
In the case of a negative interest rate gap, RSL exceeds RSA, i.e., liabilities
reprice before assets
◦ This happens when long-term assets are financed by short-term liabilities
◦ NII decreases with increase in interest rates, and vice versa
Interest Rate Risk: Measurement
The interest rate gap serves as a measure of interest rate sensitivity
The change in NII is the product of the interest rate gap and the change in the
interest rate:
∆𝑁𝐼𝐼 = 𝑅𝑆𝐴 − 𝑅𝑆𝐿 ∗ ∆𝐼
Example:
A bank has RSA of ₹600 million and RSL of ₹400 million in a time bucket
The interest rate gap is ₹200 million
If the interest rate increases by 1%, the NII of the bank will increase by:
₹(600-400)*0.01 = ₹2 million
The Management of Net Interest Income
A key risk management activity for a bank is the management of net interest
income (NII).
The net interest income is the excess of interest received over interest paid.
It is the role of the asset-liability management function within the bank to
ensure that the net interest margin (NIM), which is net interest income divided
by income producing assets, remains roughly constant through time.
The Management of Net Interest Income
Consider a simple situation where a bank offers consumers a one-year and a
five-year deposit rate as well as a one-year and five-year mortgage rate (i.e.,
home loan interest rate).
Assume that the market participants consider interest rate increases to be just
as likely as interest rate decreases.
The Management of Net Interest Income
Suppose you have money to deposit and agree with the prevailing view that
interest rate increases are just as likely as interest rate decreases.
Would you choose to deposit your money for one year at 3% per annum or for
five years at 3% per annum?
The chances are that you would choose one year because this gives you more
financial flexibility.
It ties up your funds for a shorter period of time.
The Management of Net Interest Income
Now suppose that you want a mortgage.
Again you agree with the prevailing view that interest rate increases are just as
likely as interest rate decreases.
Would you choose a one-year mortgage at 6% or a five-year mortgage at 6%?
The chances are that you would choose a five-year mortgage because it fixes
your borrowing rate for the next five years and subjects you to less refinancing
risk.
The Management of Net Interest Income
When the bank posts the rates as shown, it is likely to find that the majority of
its depositors opt for a one-year maturity and the majority of the customers
seeking mortgages opt for a five-year maturity.
This creates an asset/liability mismatch for the bank and subjects its net interest
income to risks.
The Management of Net Interest Income
The deposits that are financing the five-year 6% mortgages are rolled over every
year.
There is no problem if interest rates fall. After one year, the bank will find itself
financing the five-year 6% mortgages with deposits that cost less than 3% and
net interest income will increase.
However, if interest rates rise, the deposits that are financing the 6% mortgages
will cost more than 3% and net interest income will decline. Suppose that there
is a 3% rise in interest rates during the first two years. This would reduce net
interest income for the third year to zero.
It is the job of the asset-liability management group to ensure that this type of
interest rate risk is minimized.
The Management of Net Interest Income
One way of doing this is to ensure that the maturities of the assets on which
interest is earned and the maturities of the liabilities on which interest is paid
are matched.
In our example, the matching can be achieved by increasing the five-year rate on
both deposits and mortgages.
Example:
The Management of Net Interest Income
This would make five-year deposits relatively more attractive and one-year
mortgages relatively more attractive.
Some customers who chose one-year deposits earlier will now choose five-year
deposits. Some customers who chose five-year mortgages earlier will now
choose one-year mortgages.
This may lead to the maturities of assets and liabilities being matched.
If there is still an imbalance with depositors tending to choose a one-year
maturity and borrowers a five-year maturity, five-year deposit and mortgage
rates could be increased even further.
Eventually the imbalance will disappear.
The Management of Net Interest Income
The net result of all banks behaving this way is that long-term rates tend to be
higher than those predicted by expected future short-term rates.
This phenomenon is referred to as liquidity preference theory.
It leads to long-term rates being higher than short-term rates most of the time.
Even when the market expects a small decline in short-term rates, liquidity
preference theory is likely to cause long-term rates to be higher than short-term
rates.
Only when a steep decline in interest rates is expected will long-term rates be
lower than short-term rates.
The Management of Net Interest Income
Many banks now have sophisticated systems for monitoring the decisions being
made by customers so that, when they detect small differences between the
maturities of the assets and liabilities being chosen, they can fine-tune the rates
they offer.
Interest Rate Risk: Management using
Derivatives
The following types of derivatives are generally used to manage interest rate
risk:
Interest rate swaps
◦ Contracted immediately, or
◦ Effective later (forward swaps)
Caps or floors, collars
Option on interest rate swaps (swaption)
◦ Right to enter into a swap at a later date, but not an obligation
Example
A firm has a floating rate debt of ₹15 million. The firm rolls over this debt every
quarter.
To protect itself against the risk of rise in interest rates, the firm buys an interest
rate cap. The strike interest rate under the cap is 6%
The rate is reset after every quarter and the reference rate used for the cap is
the government treasury rate.
The reference rate is 5.50% at the end of the first quarter. In this case, there is
no payoff under the cap
At the end of the second quarter, the reference rate is 6.25%. The firm will get
compensation from the cap seller: 15mn*(0.0625-0.06)*(90/360) = ₹9,375
Liquidity Funding Risk
Liquidity funding risk can arise out of
◦ external market conditions or
◦ due to internal factors within the firm
Liquidity funding risk is measured using liquidity gaps that represent the
difference between assets and liabilities at future dates
◦ When the amount of assets exceed liabilities: deficit of funds
◦ When the amount of liabilities exceed assets: surplus of funds
Management of liquidity funding risk involves managing the maturities of assets
and liabilities so as not to leave significant gaps
Liquidity Funding Risk
Funding programs should be suitably spread out and unexpected funding should
be avoided
There should be a cushion of liquid assets that can be sold to provide liquidity
without incurring excessive costs
Further Reading
Interest Rate Risk: Measurement
An asset or liability is treated as rate sensitive in a time bucket if:
(a) There is a cash flow within the time bucket
(b) There is an interest rate reset in the time bucket
(c) There is an administered rate change* in the time bucket
(d) Prepayment or withdrawal before maturity is allowed under the contract

* Administered rate change refers to change in rate by an external authority like

RBI
Back
Interest Rate Risk: Measurement
A bank provides the following information about RSA and RSL over the next 3
maturity months:
If the interest rate increases by 1%, the NII over the 3-month period will increase
by?

Maturity Month 1 2 3
RSA (₹ million) 200 240 300
RSL (₹ million) 40 60 80
Gap 160 180 220
Cumulative Gap 160 340 560
Interest Rate Risk: Measurement
Change in NII (Based on cumulative gap):
= 0.01*1/12*(160+340+560)
= 0.883

Alternatively,
Change in NII (Based on monthly gap):
= (160*0.01*3/12)+(180*0.01*2/12)+(220*0.01*1/12)
= 0.883
Interest Rate Risk: Measurement
Steps in gap analysis (Preparation of gap report)
1. Specification of time buckets
2. Mapping of assets and liabilities to the time buckets
3. Calculation of cumulative gaps
4. Defining gap limits (permitted as per the bank’s risk management policy)
5. Estimating impact of gaps on NII
Organization of the ALM Function
The ALM function is responsible for managing the interest rate risk and liquidity
of the bank
It has two units:
◦ The Technical Unit
◦ The Asset and Liability Committee (ALCO)
The technical unit develops models for ALM and prepares all analyses that are
used by the ALCO for taking decisions
ALCO lays down the guidelines and policy w.r.t. interest rate risk and liquidity risk
for the banking portfolio
ALCO is a high-level committee, chaired by the CEO and comprises of senior
executives of the bank